Last Thursday, Rolls-Royce Holding PLC (LON:RR) announced that it had forwarded information to the Serious Fraud Office (SFO) relating to concerns about bribery and corruption involving intermediaries in overseas markets following a request for information from the SFO about allegations of malpractice in Indonesia and China. While the multinational power systems company headquartered in London currently receives favorable ratings across our platform of risk assessment tools, news of corruption investigations and possible prosecution are sure to have a significant effect on our overall analysis.

Malpractice allegations against Rolls-Royce are said to occur at some point between 1996 and 2002 when a “well-connected” individual in Indonesia allegedly gave $20 million and a blue Rolls-Royce car to the son of Suharto, the former president and dictator of Indonesia, to supply Rolls-Royce aircraft engines to a carrier. (The dictator’s son was jailed in 2002 for giving an order to assassinate a Supreme Court judge.) The allegations come from whistleblower Dick Taylor, who worked for Rolls-Royce for over 30 years, and said that he was “forced into early retirement” after he complained that a manager was falsely claiming company expenses in Indonesia. After his complaints went unheeded, Mr. Taylor began posting bribery allegations in the comments below articles about the company on websites around the world before the SFO finally took notice.

The SFO’s investigation is said to include allegations of malpractice in Indonesia, China, as well as “matters of concern” in other overseas markets. Furthermore, the US Department of Justice has also been notified. Any disruption to the company’s business overseas could be especially damaging news to the British engineering group’s investors. According to the company’s 2011 Annual Report only £1,361 million of the company’s 2011 total revenues of £11,124 million originated from the United Kingdom, compared to £934 million from business in China and £1,778 million in the Middle East and South East Asia region. Notably, while 2011 revenues from the United Kingdom fell nearly 15% from 2010 and revenues from the rest of Europe fell almost 17%, revenues from the United States increased about 16%. Similarly gains were made in China and other Asian regions. Clearly, Rolls-Royce is placing a greater emphasis on non-European revenue streams; corruption and bribery scandals, especially if the company or its employees are prosecuted, thusly pose significant threats to its international trade.

In the company’s defense, Rolls-Royce reported that it “has significantly strengthened its compliance procedures in recent years, including a new Global Ethics Code and a new Intermediaries Policy.” The company also announced that it will appoint an independent senior figure to lead a review of current procedures and report to the Ethics Committee of the board. Chief executive officer John Rishton said: “I want to make it crystal clear that neither I nor the board will tolerate improper business conduct of any sort and will take all necessary action to ensure compliance. This is a company with exceptional prospects and I will not accept any behaviour that undermines its future success.”

It is important to note that Rolls-Royce’s Ethics Committee was established only in 2008, years after the purported allegations took place. Why it took so long for a company of its magnitude and international reach to establish a board-level ethics committee is not known, but it is a clear indication that Rolls-Royce did not necessarily take seriously the short- and long-term risks of bribery and corruption in a global organization. While the company’s 2011 annual report stated that it “completed a review of its anti-bribery and corruption related policies and procedures,” we are curious to hear what exactly the company will say to the SFO regarding its dismissive behavior toward the whistleblower’s allegations. After all, it is one thing to have an Ethics Committee, but it is an entirely different thing to adhere to its core tenets.

In a related aside, in response to the 2011 Davies report on “Women on Boards” in which the importance of increased gender diversity on UK boards was stressed, Rolls-Royce stated its commitment “to improving diversity at all levels of leadership in Rolls-Royce and to making appointments based on merit at the most senior levels of our organisation.” As of December 2012, however, only 2 of 15 board members are women; its 5-member executive board includes no female members; and only 1 of 16 group leadership team members are women. Again, Rolls-Royce is culpable of saying all the right things without demonstrable action to back its assertions.

In fact, upon closer scrutiny of Rolls-Royce’s Ethics Committee, there are several possible clues as to its purported inefficacy. For example, we note with some irony that the committee’s chair, Ian Strachan, serves on the board of Swiss offshore drilling company Transocean, one of the companies implicated in the 2010 Deepwater Horizon drilling rig explosion in the Gulf of Mexico that caused 11 deaths and rampant environmental destruction. Transocean (rated “F” by GMI Ratings) awarded its executives bonuses for 2010 safety measures and infamously said in its proxy statement that “notwithstanding the tragic loss of life in the Gulf of Mexico, we achieved an exemplary statistical safety record.” Mr. Strachan is one of the longest serving directors at Transocean, having served since 1999. Furthermore, of the three other members of Rolls-Royce’s Ethics Committee, none have a background or experiences that would suggest a proficiency in matters related to ethics oversight.

No matter the outcome of the investigations, news of the bribery allegations and possible prosecutions have already caused immediate impact to Rolls-Royce’s share price, having fallen from a closing price of 913.50p on December 5 to 885.00p the next day and as low as 870.00p on December 11. Likewise, Rolls-Royce risk assessment ratings are also in clear danger of significant downgrades. The company’s AGR Rating—a comprehensive measure of corporate integrity based on an extensive evaluation of metrics which study financial results and corporate behavior—stood at 86 (“Conservative”) in March 2012 but has since fallen to 76 (“Average”) in June and then 67 in September. This places them in the 67th percentile among all companies in Western Europe, indicating higher accounting and governance risk than 33% of companies. While its AGR Rating is not necessarily cause for alarm, its downward trajectory is certainly notable.

Similarly, while Rolls-Royce does not currently represent significant long-term sustainability risk according to its overall ESG Rating, the company’s rating is slowly slipping; as of March 2012 it stood at 96 but has since fallen twice to its current score of 84. Our Litigation Risk model is following a similar trend, having fallen from a 39 (meaning “Negligible Risk”) at the end of June to its current score of 29 (“Moderate Risk”). This places Rolls-Royce in the 29th percentile of all companies in Western Europe, indicating higher shareholder class action litigation risk than 71% of all rated companies in this region.

Finally, it is important to note that bribery allegations at Rolls-Royce may be an indication of an emerging trend in the UK’s Aerospace and Defense sector as competitor BAE Systems pled guilty in 2010 to criminal charges and paid nearly $450 million in penalties in the US and UK to end long-running investigations into questionable payments. According to industry sources, “The UK authorities are focusing intently on overseas corruption, and the pace of activity seems to be increasing … In focusing on the aerospace and defence sectors, the UK authorities seem to be following a path forged by their U.S. counterparts.” We expect these cases to increase based on anecdotal evidence that the industry is “seen as vulnerable to corruption because secretive deals with government officials are often viewed as a necessary part of the business.”